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Posts Tagged ‘Moral Hazard’

I periodically comment about government corruption, often in the context of trying to make the general point that shrinking the size and scope of the public sector is the most effective way of reducing sleaze in Washington.

Now let’s get specific. I’ve already cited Obamacare, the tax code, and the Export-Import Bank as facilitators of corruption. Let’s augment that list by looking at government intervention in the financial sector.

We’ll start with some findings on the effectiveness of lobbying. In some new research, two professors at George Mason University’s Mercatus Center found that being active in Washington is beneficial for top executives, but it doesn’t help a company’s bottom line.

Here’s how the Washington Examiner summarized the study.

What is the return on investment in lobbying? Does a PAC contribution actually pay for itself? There are so many cases of a lobbyist winning an earmark, or a PAC contribution immediately preceding a subsidy, that it’s hard not to see politics as a good investment. …But for every company that hits the jackpot after lobbying campaign, scores of others end up throwing away money on lobbyists — and scores of executives whose PAC contributions don’t help the company a bit. Business professors Russell Sobel and Rachel Graefe-Anderson of the Mercatus Center at George Mason University collected the data and dug into the bigger question: Do lobbying expenditures and PAC contributions increase corporate profits, on average? Their answer: No… When Sobel and Graefe-Anderson crunched numbers, conducted regressions, and controlled for firm size, industry and other factors, they arrived at data “suggesting that any benefits gained from corporate political activity are largely captured by firm executives.” In short, when a CEO and a lobbyist decide to get their company more involved in politics, the CEO and the lobbyist benefit, while not helping the company.

These findings at first struck me as counterintuitive. After all, there are plenty of companies, such as General Electric and Archer Daniels Midland, that seem to obtain lots of unearned profits thanks to their lobbying activities.

But don’t forget that government – at best – is a zero-sum game. So for every company, industry, or sector that “wins,” there will be lots of companies, industries, and sectors that suffer.

And speaking of industries that benefit, there was one exception to the Mercatus Center findings.

The only exception was the banking and financial sectors, where they found “positive and significant correlations between firm lobbying activity and three measures of firm financial performance,” including return on investment and return on equity.

At this stage, let’s be careful to specify that lobbying is not necessarily bad. If a handful of business owners want to join forces to fight against higher taxes or more regulation, I’m all in favor of that kind of lobbying. They’re fighting to be left alone.

But a big chunk of the lobbying in Washington is not about being left alone. It’s about seeking undeserved benefits by using the coercive power of government.

And this latter definition is a good description of what the financial industry has been doing in Washington. That’s bad for taxpayers, but it’s also bad for the financial sector and the overall economy. Here are some of the conclusions from a recent study published by the New York Federal Reserve Bank.

…there have been many concerns with banks deemed “too big to fail.” These concerns derive from the belief that the too-big-to-fail status gives large banks a competitive edge and incentives to take on additional risk. If investors believe the largest banks are too big to fail, they will be willing to offer them funding at a discount. Together with expectations of rescues, this discount gives the too-big-to-fail banks incentives to engage in riskier activities. …The debate around too-big-to-fail banks has given rise to a large literature. … we study whether banks that rating agencies classify as likely to receive government support increase their risk-taking. …The results of our investigation show that a greater likelihood of government support leads to a rise in bank risk-taking. Following an increase in government support, we see a larger volume of bank lending becoming impaired. Further, and in line with this finding, our results show that stronger government support translates into an increase in net charge-offs. Additionally, we find that the effect of government support on impaired loans is stronger for riskier banks than safer ones, as measured by their issuer default ratings. …the level of impaired loans in a bank loan portfolio increases directly with the level of government support. …riskier banks are more likely to take advantage of potential sovereign support.

Isn’t that wonderful. Our tax dollars have been used to increase systemic risk and undermine economic growth. Though none of us should be surprised.

Since this has been a depressing column, let’s enjoy some morbid TARP humor.

Here’s a cartoon from Robert Ariail about the cronies who got rich from the Bush-Obama bailouts.

Good to see Hank Paulson getting ripped. At the end of the Bush Administration, I attempted to convince the White House that “FDIC resolution” was a much better way of recapitalizing the banking system. I was repeatedly told, though, that Paulson was in charge and there was no way of stopping him from bailing out his former cronies on Wall Street.

Oh well, at least I tried.

Here’s another cartoon about the real victims of TARP. Like the first cartoon, it’s an oldie but goodie and it’s a good illustration of how government is a zero-sum scam.

But let me re-emphasize a point I made above. Taxpayers aren’t the only ones to lose. The entire economy suffers from bailouts and subsidies. Such policies distort the allocation of capital and lead to slower long-run growth.

That may not be easy to measure, but it matters a lot.

Here’s a video explaining how such policies create moral hazard.

This is a good time to recycle the famous poster about supposed government solutions.

P.S. Not all financial institutions are corrupted by government. The nation’s 10th-largest bank, BB&T, did not want and did not need a bailout. But as the bank’s former CEO (and, I’m proud to say, current Cato Institute president) explained in his book, thugs from Washington threatened to use regulatory coercion if BB&T didn’t participate.

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When you support limited government and individual freedom, you don’t enjoy many victories. Particularly if you’re relying on the U.S. Senate.

But it occasionally happens.

The Senate held firm and stopped Obama from getting a fiscal cliff tax hike at the end of 2010.

The Senate overwhelmingly voted against a VAT.

The Senate unanimously rejected a Greek bailout.

To be sure, some of these votes were merely window dressing, but it’s still better to have symbolic victories rather than symbolic defeats.

Today, however, I want to report on a real victory against statism. The Senate Majority Leader, Harry Reid, has been forced to give up on his effort to ram through an expansion of IMF bailout authority as part of legislation giving money to Ukraine.

This is the second time that this White House initiative has been blocked.

Here are some blurbs from a report in Politico.

Senate Majority Leader Harry Reid will drop a provision to reform the International Monetary Fund from a bill to help Ukraine… Reid acknowledged that while the Ukraine package would likely have passed the Senate, it was “headed to nowhere” in the GOP-led House. …the administration did not hide its disappointment Tuesday afternoon over the removal of the IMF language. “We are deeply disappointed by the news that Republican opposition has forced the Senate to remove the [IMF] reforms from the Ukraine assistance package,” said Treasury Department spokeswoman Holly Shulman. …Backers of including the IMF reforms in the Ukraine deal note that it will help boost the organization’s lending capacity. …The United States is the lone holdout country that has not ratified the IMF deal, which was struck more than three years ago. But many congressional Republicans have raised concerns about potential taxpayer risk with the IMF agreement.

It goes without saying that the IMF won’t give up, and the Obama Administration is still pushing to expand the international bureaucracy’s bailout authority.

The battle will continue. Lew and ObamaIn preparation for the next skirmish, Desmond Lachmann at AEI debunks the White House’s empty talking points.

Next week, Treasury Secretary Jack Lew will make his case before the House Financial Service Committee for linking IMF reform to U.S. bilateral aid for Ukraine. If the past is any guide, he will do so by putting forward a set of disingenuous arguments in favor of his case. …The principal argument that Secretary Lew must be expected to make is that IMF quota reform is essential for large-scale IMF Ukrainian financial support. This argument glosses over the fact that under the IMF’s lending policy under “exceptional circumstances”, which has been resorted to on many occasions since the 1994 Mexican tequila crisis, the amount that the IMF can lend a country bears little relation to the size of that country’s IMF quota.  …Ukraine is reportedly currently seeking around a U.S. $15 billion IMF economic adjustment loan. If Mr. Lew were to be candid, he would inform Congress that such an amount represents only around 800 percent of Ukraine’s present IMF quota or less than half the amount of quota that the IMF recently committed to several countries in the European economic periphery. He would also inform Congress that the IMF presently has more than U.S. $400 billion in uncommitted loanable resources. This would make the IMF’s prospective loan to Ukraine but a drop in the IMF’s large bucket of available resources even without IMF reform.

Lachmann goes on to make additional points, including the fact that IMF bailouts create very real financial risks for American taxpayers.

The U.S. Treasury never tires of assuring Congress that large-scale IMF lending poses no risk to the US taxpayer. It bases its argument on the fact that the IMF enjoys preferred creditor status and that to date no major country has defaulted on its IMF loans. However, the Treasury conveniently glosses over the fact that IMF loan repayment experience with past IMF lending on a small scale might not be a good guide to what might happen on IMF loans of an unprecedentedly large scale. To understand that there now might be a real risk to the US taxpayer from IMF lending, one only need reflect on the IMF’s current Greek lending experience. Greece’s public debt is now mainly officially owned and it amounts to over 175 percent of GDP. It is far from clear that the European Central Bank will go along with the idea that the IMF enjoys senior status over the ECB in terms of Greece’s loan repayments.

His point about risks to taxpayers is right on the mark. In effect, the IMF is like Fannie Mae and Freddie Mac. For years, defenders of intervention in the housing market argued those government-created entities didn’t cost a penny. Then they suddenly cost a lot.

The same will happen with the IMF.

Lachmann closes by asking the right question, which is whether there’s any reason to expand the IMF’s authority.

I think that’s the real issue. And to answers that question, let’s go to Mark Hendrickson’s column in Forbes.

He starts by noting that the IMF has “re-invented” itself to justify its existence, even though it supposedly was created for a world – which no longer exists – of fixed exchange rates.

Bureaucracies are masters of mission creep. They constantly reinvent themselves, cleverly finding ways to expand in size, scope, power, and budget. The IMF has perfected this art, having evolved from its original purpose of trying to facilitate orderly currency exchange rates as countries recovered from World War II to morphing into a global busybody that makes loans—with significant strings attached—to bankrupt governments.

And what do we get in exchange for being the biggest backer of IMF bailouts?

What has the American taxpayer received in return for billions of dollars siphoned through the IMF to deadbeat governments? Nothing but ill will from abroad. First, the IMF’s policy of lending millions, or billions, to fiscally mismanaged governments is counterproductive: Such bailouts help to prop up inept and/or corrupt governments. Second, bailouts create moral hazard, inducing private corporations and banks to lend funds to poor credit risks, confident that IMF funds will make them whole. Third, typical IMF rescue packages demand…higher taxes in the name of balancing the budget.

It would be far better, Professor Hendrickson explains, if reckless governments had to immediately accept the market’s judgement whenever they overspent.

…it doesn’t take expert economists to figure out when a government is overspending. Markets will discipline spendthrift governments by ceasing to make funds available to them until they institute needed reforms. Without a bailout fairy like the IMF, government leaders will quickly learn that if they wish the government to remain viable, they must spend within available means. By telling governments what they “have” to do when it’s obvious they need to make those reforms anyhow, the IMF gives the recipient government a convenient scapegoat. It blames the pain of austerity on meddlesome foreigners, and since the U.S. is perceived as the real power in the IMF, we get painted as the bad guys. The bottom line: IMF use of our tax dollars buys us a ton of resentment from abroad.

He also points out that the IMF makes a habit of suggesting bad policy – even for the United States.

the IMF has waged war against American taxpayers and workers. Last October, the IMF released a paper suggesting both higher tax rates (mentioning a “revenue-maximizing” top marginal tax rate of around 60 percent) and possibly the confiscation of a sizable percentage of private assets to restore fiscal balance to the federal government. The IMF also has been one of the leading forces discouraging “tax competition” between countries. …It is using American tax dollars to lobby the American government to increase the flow of tax dollars from our Treasury to the IMF. We shouldn’t be surprised, then, that the IMF released a report on March 13 warning of the perils of “income inequality,” and suggesting tax increases and wealth redistribution as ways by which Uncle Sam might address the problem.

So what’s the bottom line?

If the IMF really wanted to improve the economic prospects of the world’s people, it would recommend reductions in government spending and taxation. Indeed, the overwhelming evidence is that vigorous economic growth is highly correlated with a country’s government shrinking as a share of GDP. What are the chances that the IMF will ever advocate such policies? Not very, as we realize that the IMF’s very existence depends on government taxes. …In a better world, there wouldn’t be an IMF. For the present, though, the best we can hope for is for enough members of Congress to understand that the IMF’s interests are opposed to those of the American people and to refuse any requests that the IMF makes for increased funding.

The Wall Street Journal is more measured in its rhetoric, but it basically comes to the same conclusion.

Republicans are reluctant to grant more leverage to European countries, which they blame for relaxing rules on Greece’s bailout in order to rescue the continent’s banks. …An internal audit last week also found that the fund’s growth forecasts were “optimistic” for countries like Greece and Ukraine that were granted larger loans under its “exceptional access” framework. Republicans fear the IMF is becoming a discount borrowing window for spendthrift governments trying to postpone reforms. IMF economic advice is often lousy—raise taxes and devalue… Congress ought to debate whether the IMF has outlived its usefulness as it evolves from a tool for Western interests into a global check-writing bureaucracy.

Amen. Which is why the United States should shut the Treasury door to the IMF. If other nations want to subsidize bad policy and promote bigger government, they can do it with their own money.

P.S. Here’s a list of other IMF transgressions against good public policy (all partially backed by American taxpayers).

Endorsing government cartels to boost tax and regulatory burdens.

Trying to undermine flat tax systems in Albania and Latvia.

Encouraging a “collective response” to over-spending in welfare states.

Pushing for higher tax burdens in Greece.

Seeking the same destructive policy in Cyprus.

Advocating for more centralization and bureaucratic rule in Europe.

Urging higher taxes in El Salvador.

Supporting “eurobonds” so that taxpayers from other nations can subsidize the profligacy of welfare states such as Greece, Italy, and Spain.

Pushing an energy tax that would mean $5,500 of added expense for the average American household.

Reflexively endorsing every possible tax increase.

Aiding and abetting Obama’s “inequality” agenda with disingenuous research.

And remember, these pampered bureaucrats get lavishly compensated and don’t have to pay tax on their bloated salaries.

P.P.S. But let’s be fair to the IMF. The bureaucrats have given us – albeit unintentionally – some very good evidence against the value-added tax.

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For my birthday last year, the only present I wanted was for the Supreme Court to uphold the Constitution and reject Obamacare.

Needless to say, that didn’t happen. Instead, the Chief Justice put politics above the law and made a mockery of his Oath of Office.

So I’m now a bit superstitious and I’m not going to write about anything I want today or in the future. But I will pretend that something good happened because it’s my birthday, so let’s celebrate the fact that the European Union has basically made the right decision on how to deal with insolvent banks.

Technically, it happened yesterday, the day before my birthday, but it’s being reported today, and that’s close enough for me. Here are some details from the EU Observer.

Bank shareholders and creditors will be first in line to suffer losses if their bank gets into difficulties, according to draft rules agreed by ministers in the early hours of Thursday morning… Under the new regime, banks’ creditors and shareholders would be the first to take losses. But if this proves insufficient to rescue the bank in question, savers holding uninsured deposits worth more than €100,000 would also take a hit.

This is basically the “FDIC-resolution” approach that I’ve mentioned before, and it’s sort of what happened in Cyprus (after the politicians tried every other option).

And it’s the opposite of the corrupt TARP system that the Bush and Obama Administrations imposed on the American people.

The reason this new European approach is good is that it puts the pressure for sound business decisions where it belongs – with the shareholders who own the bank and with the big creditors (such as bondholders) who should be responsible for monitoring the underlying safety and soundness of a bank before lending it money.

And rich people (depositors with more than €100,000) also should be smart enough to apply some due diligence before putting their money someplace.

The last people to bear any costs should be taxpayers. They don’t own the bank. They don’t invest in the bank. And they don’t have big bucks. So why should they bear the cost when the big-money people screw up?!? Especially when TARP-style bailouts promote moral hazard!

I’m sure the new system won’t be properly implemented, that there are some bad details in the fine print, and there will be too many opportunities for back-door bailouts and cronyism, but let’s not make the perfect the enemy of the good.

Happy Birthday to me. And such an unexpected present: Something good actually came out of Europe!

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It doesn’t create a lot of confidence in Europe that tiny little Cyprus, with a GDP less than Vermont, is now causing immense turmoil.

Though to be more accurate, events in Cyprus aren’t causing turmoil as much as they’re causing people to examine both government finances and bank soundness in other nations. And that’s causing anxiety because folks have taken their heads out of the sand and looked at the reality of poor balance sheets.

Looking closer at the specific mess in Cyprus, an insolvent financial sector is the cause of the current crisis, though the problem is exacerbated by the fact that the government has dramatically increased the burden of government spending in recent years and therefore isn’t in a position to finance a bailout.

But that then raises the question of why Cyprus is bailing out its banks? Why not just let the banks fail?

Well, here’s where things get messy, particularly since we don’t have a lot of details. There are basically three options for dealing with financial sector insolvency.

  1. In a free market, it’s easy to understand what happens when a financial institution becomes insolvent. It goes into bankruptcy, wiping out shareholders. The institution is then liquidated and the recovered money is used to partially pay of depositors, bondholders, and other creditors based on the underlying contracts and laws.
  2. In a system with government-imposed deposit insurance, taxpayers (or bank consumers via insurance premiums) are on the hook to compensate depositors when the liquidation occurs. This is what is called the “FDIC resolution” approach in the United States.
  3. And in a system of cronyism, the government gives taxpayer money directly to the banks, which protects depositors but also bails out the shareholders and bondholders and allows the institutions to continue operating.

As far as I can determine, Cyprus wants to pick the third option, sort of akin to the corrupt TARP regime in the United States. But that approach can only work if the government has the ability to come up with the cash when banks go under.

I’m assuming, based on less-than-thorough news reports, that this is the real issue for Cyprus. It needs taxpayers elsewhere to pick up the tab so it can bail out not only depositors, but also to keep zombie banks operating and thus give some degree of aid to shareholders and bondholders as well.

But other taxpayers don’t want to give Cyprus a blank check, so they’re insisting that depositors have to take a haircut. In other words, the traditional government-imposed deposit insurance regime is being modified in an ad hoc fashion.

And this is why events in tiny Cyprus are echoing all over Europe. Folks in other nations with dodgy banks and unsound finances are realizing that their bank accounts might be vulnerable to haircuts as well.

So what should be done?

I definitely think the insolvent institution should be liquidated. The big-money people should suffer when they mismanage a bank. Shareholders should lose all their money. Then bondholders should lose their money.

Then, if a bailout is necessary, it should go only to depositors (though I’m not against the concept of giving them a “haircut” to save money for taxpayers).

But Cyprus apparently can’t afford even that option. And the same is probably true of other European nations.

In other words, there isn’t a good solution. The only potential silver lining to this dark cloud is that people are sobering up and acknowledging that the problem is widespread.

Whether that recognition leads to good policies to address the long-run imbalances – such as reductions in the burden of government spending and the implementation of pro-market reforms – remains to be seen.

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I have a serious question for readers. What’s worse, bailouts for government or bailouts for the private sector?

Yes, both are bad, but is it worse to bail out a bankrupt entitlement program, such as Social Security, or it is worse to bail out an industry, such as the financial sector?

Bailout gravy train cartoonTo bail out the housing sector, or to bail out Medicare? Fannie and Freddie, or GM and Chrysler?

All these examples involve huge amounts of money, and both private-sector and public-sector bailouts have perverse long-run effects, but which is worse?

And don’t forget there are lots of other bailouts in our future, as discussed on this interview for Fox Business News.

The interview took place before Christmas, but the topic is even more relevant today since the budget season is about to begin.

Most of the discussion was about government agencies and programs that may get more handouts, though bailouts for the Federal Housing Administration and the Pension Benefit Guaranty Corporation would be indirect bailouts for big business and housing.

So we’d get the worst of all worlds, more government spending and more cronyism.

Or, as they call it in Washington, a win-win situation.

But I call it legal corruption.

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I think it’s a mistake to bail out profligate governments, and I have the same skeptical attitude about bailouts for mismanaged banks and inefficient car companies.

Simply stated, bailouts reward past bad behavior and make future bad behavior more likely (what economists call moral hazard).

But some folks think government was right to put taxpayers on the hook for the sloppy decisions of private companies. Here’s the key passage in USA Today’s editorial on bailouts.

Put simply, the bailouts worked. True, in some cases the government did not do a very good job with the details, and taxpayers are out $142 billion in connection with the non-TARP takeovers of housing giants Fannie Mae and Freddie Mac. But it’s time for the economic purists and the Washington cynics to admit that government can occasionally do something positive, at least when faced with a terrifying crisis.

Well, I guess I’m one of those “economic purists” and “Washington cynics,” so I’m still holding firm to the position that the bailouts were a mistake. In my “opposing view” column, I argue that the auto bailout sets a very bad precedent.

Unfortunately, the bailout craze in the United States is a worrisome sign cronyism is taking root. In the GM/Chrysler bailout, Washington intervened in the bankruptcy process and arbitrarily tilted the playing field to help politically powerful creditors at the expense of others. …This precedent makes it more difficult to feel confident that the rule of law will be respected in the future when companies get in trouble. It also means investors will be less willing to put money into weak firms. That’s not good for workers, and not good for the economy.

If I had more space (the limit was about 350 words), I also would have dismissed the silly assertion that the auto bailout was a success. Yes, GM and Chrysler are still in business, but the worst business in the world can be kept alive with sufficiently large transfusions of taxpayer funds.

And we’re not talking small amounts. The direct cost to taxpayers presently is about $25 billion, though I noted as a postscript in this otherwise humorous post that experts like John Ransom have shown the total cost is far higher.

And here’s what I wrote about the financial sector bailouts.

The pro-bailout crowd argues that lawmakers had no choice. We had to recapitalize the financial system, they argued, to avoid another Great Depression. This is nonsense. The federal government could have used what’s known as “FDIC resolution” to take over insolvent institutions while protecting retail customers. Yes, taxpayer money still would have been involved, but shareholders, bondholders and top executives would have taken bigger losses. These relatively rich groups of people are precisely the ones who should burn their fingers when they touch hot stoves. Capitalism without bankruptcy, after all, is like religion without hell. And that’s what we got with TARP. Private profits and socialized losses are no way to operate a prosperous economy.

The part about “FDIC resolution” is critical. I’ve explained, both in a post criticizing Dick Cheney and in another post praising Paul Volcker, that policymakers didn’t face a choice of TARP vs nothing. They could have chosen the quick and simple option of giving the Federal Deposit Insurance Corporation additional authority to put insolvent banks into something akin to receivership.

Indeed, I explained in an online debate for U.S. News & World Report that the FDIC did handle the bankruptcies of both IndyMac and WaMu. And they could have used the same process for every other poorly run financial institution.

But the politicians didn’t want that approach because their rich contributors would have lost money.

I have nothing against rich people, of course, but I want them to earn money honestly.

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This past Monday, I took part in a panel discussion about the financial crisis at the European Resource Bank in Brussels.

One of my main points was that people in private markets always make mistakes, but that this is a healthy and necessary process so long as there is a profit and loss feedback mechanism that encourages people to quickly learn when things go wrong (and also to reward them when they make wise decisions).

In the financial crisis, though, we saw the government interfere with this process. First, bad policies such as easy money from the Fed and corrupt Fannie Mae/Freddie Mac subsidies distorted market signals and caused a needlessly high level of mistakes. Second, bailouts interfered with the feedback mechanism, teaching people that large levels of imprudent risk are okay.

The politicians, unsurprisingly, didn’t learn the right lessons. Instead of reducing the level of government intervention, they imposed the Dodd-Frank bailout bill (named after two lawmakers who were pimps for Fannie and Freddie and thus disproportionately responsible for the crisis).

I don’t know if this is a case of too-little-too-late, but more and more people are waking up to the idea that regulation is the problem rather than the solution. Perhaps most important, some of these people are in positions of power.

Let’s begin with a look at how the Wall Street Journal’s editorial page reacted to some very important research by some uncharacteristically astute regulators from the Bank of England.

…the speech of the year was delivered at the Federal Reserve’s annual policy conference in Jackson Hole, Wyoming on August 31. And not by Fed Chairman Ben Bernanke. …BoE Director of Financial Stability Andrew Haldane and colleague Vasileios Madouros point the way toward the real financial reform that Washington has never enacted. The authors marshal compelling evidence that as regulation has become more complex, it has also become less effective. They point out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that can’t provide accurate measurements of a bank’s health. …Basel II relied far too much on the judgments of government-anointed credit-rating agencies, plus a catastrophic bias in favor of mortgages as “safe.” Instead of learning from that mistake, the gnomes have written into the new Basel III rules a dangerous bias in favor of sovereign debt. The growing complexity of the rules leaves more room for banks to pursue regulatory arbitrage, identifying assets that can be classified as safe, at least for compliance purposes. …in both the U.K. and U.S. the number of regulators has for decades risen faster than the number of people employed in finance. Complexity grows still faster. The authors report that in the 12 months after the passage of Dodd-Frank, rule-making that represents a mere 10% of the expected total will impose more than 2.2 million hours of annual compliance work on private business. Recent history suggests that if anything this will make another crisis more likely. Here’s a better idea: Raise genuine capital standards at banks and slash regulatory budgets in Washington. Abandon the Basel rules on “risk-weighting” and other fantasies of regulatory omniscience.

The references to the Basel regulations are particularly noteworthy. These are the rules, cobbled together by regulators from different nations, and they’re supposed to steer financial institutions away from excessive risk.

You won’t be surprised to learn, though, that these rules caused imprudent behavior. Indeed, one of the slides from my presentation in Brussels specifically highlighted the perverse impact of the Basel regulations.

Some American regulators also understand the inverse relationship between regulation and well-functioning markets. The Wall Street Journal opines on the words of Thomas Hoenig.

The same “fundamentally flawed” system of financial rules that failed in 2008 lives on, “but with more complexity” in the latest proposals from regulators. That was the blunt message on Friday from Federal Deposit Insurance Corporation Director Thomas Hoenig. He was talking about the pending implementation of international bank capital standards known as Basel III. …Mr. Hoenig did a public service at an American Banker symposium by reviewing the relevant history from 2008: “It turns out that the Basel capital rules protected no one: not the banks, not the public, and certainly not the FDIC that bore the cost of the failures or the taxpayers who funded the bailouts. The complex Basel rules hurt, rather than helped the process of measurement and clarity of information.” Observing a Basel system that only grows more complicated as U.S. regulators prepare to implement the latest version, the former president of the Federal Reserve Bank of Kansas City also pointed out that the biggest winners from such regulatory regimes are never the little guys. Mr. Hoenig explained that “the most brazen and connected banks with the smartest experts will game the system…”

I closed my remarks in Brussels by saying that government does have a role in financial markets, but I said that it should focus on identifying and punishing fraud. The free market, by contrast, is the best way to promote safety and soundness.

More specifically, there is nothing quite like the possibility of failure and losses to encourage prudent behavior. As I stated in this interview, capitalism without bankruptcy is like religion without hell.

Hell, by contrast, occurs when government intervenes and sets up a system of private profits and socialized losses.

P.S. The financial crisis doesn’t create much opportunity for humor, but this cartoon is definitely worth a laugh.

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